The Exchange Update
A Newsletter For 1031 Tax-Deferred Exchanges
IRS Provides Time Extensions for Taxpayers in Disaster Areas
The Revenue Procedure: (1) provides a time extension of either 120 days or to the last day of the authorized general extension period, whichever is later; (2) provides extensions to the reverse exchange deadlines; and (3) clarifies who would qualify for the extensions. The additional time is added on to the last day of the applicable 45-day identification period or 180-day exchange period for both forward and reverse exchanges. The 120-day extension also applies to the 5-day timeframe taxpayers have to enter into a qualified exchange accommodation agreement when doing a reverse exchange. The time extension applies if the last day of the relevant time period falls on or after the date of the declared disaster. For example, if the IRS issues a Notice specifying that a Presidentially declared disaster began on October 21st, then any applicable time frames that began prior to this date but expired on or after the 21st would be extended.
Specific criteria must be met in order for the taxpayer to benefit from the time extension. The Revenue Procedure provides that an affected taxpayer qualifies for a postponement of the deadlines only if:
- the relinquished property was transferred on or before the date of the Presidentially declared disaster, or the transfer to the exchange accommodation titleholder was completed in a reverse exchange before that date; and
- the exchangor has difficulty meeting the exchange deadlines because:
- the relinquished or replacement property is located in the disaster area;
the principal place of business of any party to the transaction is located in the disaster area;
- any party to the transaction (or an employee involved in the 1031 exchange) is killed, injured, or missing as a result of the disaster;
- a document prepared in connection with the exchange or a relevant land record is destroyed, damaged or lost as a result of the disaster;
- a lender decides not to fund the loan, or is unable to fund the loan due to lack of flood, disaster or hazard insurance; or
- a title company cannot provide title insurance due to the disaster.
- the relinquished or replacement property is located in the disaster area;
The 120-day extension also applies if an already identified replacement property or an identified reverse exchange relinquished property is substantially damaged in the disaster.
The time extensions do not automatically apply to any disaster; they only apply if the IRS issues a Notice or News Release and if the taxpayer falls within the designated criteria. Historically these notifications have been rare, but their frequency has increased in recent years. A record 81 notices were issued in 2010, with 34 issued through April of 2011. Extensions have been granted recently to taxpayers affected by storms, tornados and flooding in Tennessee, North Carolina, Mississippi, Georgia, Oklahoma, Missouri, Alabama and Arkansas. Recent Notices and News Releases can be found on the IRS website at: http://www.irs.gov/newsroom/article/0,,id=108362,00.html.
You can be an “affected taxpayer” even if you reside outside the disaster area. Taxpayers considered to be affected taxpayers eligible for the postponement of time to file returns, pay taxes and perform other time-sensitive acts are listed in Treas. Reg. § 301.7508A-1(d)(1), and include individuals who live, and businesses whose principal place of business is located, in the covered disaster area. Taxpayers not in the covered disaster area, but whose records necessary to meet a listed deadline are in the covered disaster area, are also entitled to relief. In addition, all relief workers affiliated with a recognized government or philanthropic organization assisting in the relief activities in the covered disaster area and any individual visiting the covered disaster area who was killed or injured as a result of the disaster are entitled to relief.
The IRS automatically identifies taxpayers located in the covered disaster area and applies automatic filing and payment relief. Affected taxpayers who reside or have a business located outside the covered disaster area must call the IRS disaster hotline at 1-866-562-5227 to request this tax relief.
Closing Costs in a 1031 Exchange
IntroductionThere are two important issues to consider when determining how to handle expenses in a 1031 exchange.
The first has to do with whether handling the expense in a certain way will result in the exchange being partially taxable. There are certain categories of expenses called “exchange expenses” that can be paid with exchange funds and doing so won’t result in the transaction being partially taxable.
The second issue has to do with whether paying the expense will be evidence that the taxpayer has constructive receipt of the exchange funds. If this happens, it is as if the taxpayer is controlling or actually holding the exchange funds, and the exchange may be completely ruined because it will be considered a sale followed by a purchase rather than an exchange under federal tax law.
As with many 1031 exchange issues, there is very little guidance on this topic. This article explains generally what the issues are; however, because of the uncertainties and the technical nature of these issues, it is essential that every taxpayer have his tax advisor approve each closing statement and the manner of paying all costs, so that there are no surprises when filing his tax return.
Certain expenses paid at a closing are considered “exchange expenses” and using exchange funds to pay those expenses won’t result in any tax liability to an investor doing a 1031 exchange. For example, Revenue Ruling 72-456 provides that if exchange funds are used to pay broker’s commissions, it does not result in the transaction being partially taxable. There are no other clear rulings on this subject, but most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
- Broker’s commissions
- Exchange fees
- Title insurance fees for the owner’s policy of title insurance
- Escrow fees
- Appraisal fees required by the purchase contract
- Transfer taxes
- Recording fees
- Attorney’s fees incurred in connection with the sale or purchase of the property
Other expenses are not exchange expenses, so although exchange funds can be used to pay the expense, doing so results in the exchange being partially taxable. For example, security deposits and prorated rents are not considered exchange expenses and if exchange funds are used to pay them, the exchange will be partially taxable. This comes up when the seller of the relinquished property gives the buyer a credit at the closing for the security deposits and prorated rents. The result of the credit is as if the seller was using exchange funds to pay the security deposit and prorated rent amounts to the buyer. To avoid the tax, the seller should deposit his own funds to pay those security deposits and prorated rents to the buyer.
In addition, most tax advisors believe that fees and costs in connection with getting the loan to acquire the replacement property are costs of the loan, not costs of purchasing the replacement property, and therefore under tax law are not exchange expenses. If the investor uses exchange funds at the closing of the replacement property to pay loan costs and fees, it is likely doing so will create a tax liability. To avoid the tax liability, the buyer may want to deposit his own funds to pay any loan related expenses.
Some non-exchange expenses create a tax liability but are offset by a deduction. One example of this is property taxes. Although property taxes are not an exchange expense, the investor will get a deduction for paying the property taxes and so the liability will be offset by the deduction.
The following is a list of expenses that are typically found on a closing statement but are generally not considered exchange expenses:
- Loan costs and fees
- Title insurance fees for lender’s title insurance policy
- Appraisal and environmental investigation costs that are required by the lender
- Security deposits
- Prorated rents
- Insurance premiums
- Property taxes
Transactional Items and Constructive Receipt
A separate, but important, issue is whether paying an expense will show that the investor has constructive receipt of the exchange funds, which has the potential to ruin the entire exchange. Under these rules, exchange funds can be used to purchase the replacement property, including making deposits, and to pay for typical costs related to the sale or purchase, such as prorated rents and broker commissions. The actual wording of the regulation is that exchange funds can be used to pay “transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).”
Because of the wording of the regulations, costs that are not typically paid on a closing statement in the area where the property is located, and costs that are unrelated to the sale or purchase, may trigger a constructive receipt problem if exchange funds are used to pay them. In addition, as a result of the wording of this rule, many tax advisors caution against paying expenses with exchange funds in between the closing of the relinquished and replacement properties.
One common situation where this issue arises is when an investor wants to use exchange funds to pay rate lock-in fees to a lender. Since these fees by their nature are paid before the closing to lock in an interest rate, they do not “appear under local standards in the typical closing statement,” and therefore may trigger a constructive receipt problem. Since there is no clear IRS interpretation of this rule, investors need to discuss the issue with their tax advisors before paying unrelated expenses at a closing or any expenses in between closings.
Revenue Ruling 72-456; Treasury Regulation Section 1.1031(k)-1(g)(6) and (7); IRS Form 8824.